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By George K. Fogg

George Fogg is co-chair of the Financial Transactions & Restructuring practice at Perkins Coie and a member of the firm's Virtual Currency Team. He regularly assists clients with issues presented by new and evolving electronic payment systems, services and products. Mr. Fogg also counsels business and private equity clients, as well as banks and other institutional lenders, in commercial transactions and all aspects of complex secured and unsecured debt financings. He can be reached at 503.727.2022 or GFogg@perkinscoie.com.

Would you purchase a house if you had no information on mortgages encumbering it? Of course not; yet, that is analogous to what buyers of bitcoin¹ are doing every day--purchasing without information about liens on their bitcoins. This article identifies (1) the fatal flaw in the current Bitcoin ecosystem created by Uniform Commercial Code (“UCC”) Article 9 (Secured Transactions) and (2) the solution presented by UCC Article 8 (Investment Securities).

I. Today's Bitcoin Ecosystem -- Only Partial Transparency

A principal feature of Bitcoin is the transparency that results from having all transactions listed on a public ledger (i.e., blockchains ) that allows one to trace the ownership lineage of each Bitcoin transaction. This transparency--together with the irreversibility of each transfer of bitcoins--creates a very high level of assurance that the transferee of bitcoins is, in fact, receiving ownership of the bitcoins being transferred. These features (i.e., public record of ownership and irreversibility) are designed to mimic a transfer of cash where Party A takes the cash out of her wallet and hands it to Party B--the transfer is complete and Party B knows that she now has the cash.

Unfortunately, the transparency provided by today's Bitcoin ecosystem is not comprehensive. The public ledger only identifies ownership. It provides no information on others having an interest in the owner's bitcoins, such as lienholders. It is akin to buying a house when the buyer has perfect information on who owns the house, but no information on the mortgages on the house. It is difficult to imagine the buyer of a house worth $500,000 paying the owner $500,000 without simultaneously assuring that the $400,000 mortgage on the house is paid off.

II. How UCC Article 9 Works With Respect to Bitcoin

A. General Concepts

UCC Article 9 has been adopted, with minor variations, in all 50 states and the District of Columbia. It is the statute that provides for the creation of liens on personal property (known as “security interests”) and the rights and duties of persons granting security interests (known as “debtors”), persons receiving security interests (known as “secured parties”) and persons having an interest in the property subject to a security interest (known as “collateral”). The UCC divides collateral into types,² each of which is defined in the UCC, and provides different rules with respect to the different types of collateral. When analyzing the rights and obligations of parties to collateral, it is essential to know the type of collateral under the UCC.

Key UCC Definitions

“General intangible” means any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before extraction. The term includes payment intangibles and software.

“Money” means a medium of exchange currently authorized or adopted by a domestic or foreign government. The term includes a monetary unit of account established by an intergovernmental organization or by agreement between two or more countries.

UCC Article 9 only provides for consensual liens; that is, liens that are granted by agreement of the debtor and secured party. Once the debtor grants a security interest to the secured party, the secured party must take certain actions to “perfect” its security interest in order to have the full benefit of the rights provided by Article 9. Perfection actions differ depending on the type of collateral.

B. What 'Type' of Collateral Is Bitcoin? ³

First, it is useful to understand the types of collateral bitcoin is not. Bitcoin is not “money” as defined by the UCC (and “currency” is not a type under Article 9). For a medium of exchange to be “money,” it must be authorized or adopted by a government or established by agreement of two or more countries as a unit of account.⁴ Bitcoins are not “instruments” under Article 9, because by definition instruments only exist in written form and involve the payment of money.⁵ Bitcoins are not “inventory” under Article 9, because inventory (a sub-type of goods) is limited to items that have a tangible, physical existence.⁶ Accounts in which bitcoins are held are not “deposit accounts,” because only accounts maintained by a bank are included within that defined term.⁷

Under the current Bitcoin ecosystem, bitcoins are “general intangibles”--the UCC's catchall type of collateral. If a business has a secured line of credit with a financial institution, it would be highly unusual for the collateral not to include general intangibles. Thus, one consequence (whether intended or not) of a common secured financing transaction is that any bitcoins acquired by the borrower would become subject to the lender's security interest.

This unintended consequence can be eliminated by creating the circumstances that result in bitcoins becoming a different type of collateral--“investment property”--under Article 9.⁸

As noted, the type of collateral determines the method of perfection. The most common method for a secured party to perfect its security interest is by filing a financing statement in the appropriate office (usually the Secretary of State's office) of the state in which the debtor is incorporated or formed or in which an individual debtor has his/her principal residence.

This is the sole method of perfecting a security interest in general intangibles and is one of the methods for perfecting a security interest in investment property. To be effective, the financing statement must describe the collateral, which description can be as general and vague as “all assets,” or as specific as the secured party decides to make it.

A security interest in investment property can also be perfected by control over the account in which the investment property is held. Control is most commonly accomplished by a three-party agreement (known as a “control agreement”) among the debtor, secured party and the intermediary maintaining the account. The essential element of a control agreement is the intermediary's agreement to honor instructions from the secured party (without further confirmation from the debtor). No public record of control agreements is required or maintained.

C. Security Interest Remains After Disposition of Bitcoin by Debtor

A security interest in general intangibles like bitcoin continues, notwithstanding the sale, license or other disposition of the collateral, unless the secured party consents to the transfer free of its security interest, the obligations secured by the security interest have been satisfied or the security interest has otherwise terminated.⁹ The most common exception--a buyer in the ordinary course of business takes free of security interested granted by the seller--does not apply to a purchaser of bitcoins. That exception only applies to a buyer of goods (i.e., tangible personal property)¹⁰ and nonexclusive licenses of general intangibles.¹¹ Thus, each time a bitcoin passes through the hands of an owner whose property is subject to a security interest in general intangibles that bitcoin becomes burdened with the secured party's security interest.

One possible defense to the continuing existence of security interests in bitcoins is to characterize each bitcoin as unique so that a bitcoin in the hands of the transferee is a different item of personal property than the bitcoin that was in the hands of the transferor. This defense is supported by the fact that, upon transfer, a bitcoin has a different private key for accessing it than the transferor's private key--that it is a different collection of computer code than its predecessor. It is, however, unlikely that a court would accept the proposition that an item of personal property, and the security interest in that property, was extinguished by the mere transfer of it.

D. Bitcoin Ecosystem -- Limitations of Anonymity -- UCC Implications

If Bitcoin transactions were anonymous, that is, not traceable in a manner disclosing the names of parties involved, there would be two important UCC implications.

First, a transferee could be unconcerned about a pre-existing security interest on its bitcoins, because the secured party would be unable to trace the encumbered bitcoin to the transferee. This would significantly mitigate concerns about nondisclosure of existing security interests.

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Bitcoin transactions are not entirely anonymous.

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Second, the inability of a secured party to trace its security interest could make bitcoins unattractive as collateral, which inhibits the ability of investors to leverage investments in bitcoins. This has the negative affect of stifling robust investment in bitcoins.

However, Bitcoin transactions are not entirely anonymous. Evidence of each transaction is disclosed in the permanent public ledger. Although this disclosure does not directly identify the names of the parties involved, it contains sufficient information to allow some tracing. As has been demonstrated,¹² the ability to detect patterns is sufficient to identify the flow of bitcoins through various exchanges and electronic wallet services.

Under the Department of the Treasury Financial Crimes Enforcement Network's rules,¹³ these exchanges and wallet services are required to maintain records such that one can connect a particular public key in a Bitcoin blockchain to a person or entity. Exchanges and wallet services can be compelled to provide this identifying information, so it is available, although cumbersome and difficult for private parties to obtain.

This ability to identify parties to certain types of Bitcoin transaction allows a secured party, in those circumstances, to trace the movement of its bitcoin collateral to the current owner and enforce its UCC lien rights against the owner. It also allows a prospective transferee to determine whether the bitcoin it is acquiring is subject to UCC security interests.

Currently, the ability to de-anonymize Bitcoin transactions to the point of identifying parties is difficult, but it is prudent to assume that this difficulty will be mitigated by the development of increasingly sophisticated algorithms and other methods for detecting patterns in Bitcoin transactions.¹⁴

Diminishing anonymity of Bitcoin transactions raises privacy concerns and efforts to thwart linkage of Bitcoin transactions to identified parties are ongoing.¹⁵ However, a certain degree of transparency (i.e., diminished privacy) is required to allow for a commercially viable ecosystem.

Without the ability to ascertain if bitcoins are subject to UCC security interests (and other liens), Bitcoin will not evolve beyond the novelty stage or only as a payments exchange vehicle for small person-to-person transactions. Substantial investment in bitcoins will only occur if (a) all encumbrances on title are known and (b) investments can be leveraged with debt financing (which will not occur if title is uncertain).

IV. Today's Bitcoin Ecosystem -- The Fatal Flaw

It is the combination of (a) bitcoins being general intangibles, (b) security interests in general intangibles not being automatically released upon transfer and (c) the ubiquity of security interests in general intangibles that creates the fatal flaw--bitcoins that are encumbered with security interests granted by one or more prior owners. This flaw is not avoided by transactional anonymity, because full transactional anonymity of Bitcoin transactions does not exist, and, in any event, is neither the solution, nor desirable.

V. UCC Article 8 - The Solution

A. Article 8 History

The optimal solution for dealing with security interests in bitcoins might be to revise Article 9 definitions of collateral types to create a separate category for cryptocurrencies to take them out of the catchall general intangibles type. Such a change would take years and require the adoption of statutory amendments by the states. In other words, it is not a feasible solution for this decade.

Rather, the Bitcoin ecosystem should look to the indirect holding system of financial intermediaries sanctioned under UCC Article 8 as a solution. Under an indirect holding system, the financial asset is held by a third party in an account maintained by the third party, which account is credited to the person with rights to the asset in the account.

In 1951, UCC Article 8 replaced the Uniform Stock Transfer Act of 1909. At that time, transfers of intangible rights represented by investment securities (e.g., stock certificates) were implemented by delivery of paper stock certificates. By the 1960s, the volume of securities transfers began to overwhelm the system's ability to handle paper transfers.

In response, indirect holding systems were developed where paper certificates were held by depository institutions, most notably, The Depository Trust Corporation (“DTC”). Intermediaries (e.g., stock brokers) established accounts in which their customers' ownership interests were in securities held by DTC in the brokers' or nominees' names. The 1977 revision of Article 8 was an attempt to provide rules reflecting this change as well as developing the concept of uncertificated securities. In 1994 Article 8 was once again revised to provide for more certainty¹⁶ and flexibility.¹⁷

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The security-interest uncertainties not only affect the ability of the acquirer to be certain it is receiving the value it bargained for, but also greatly diminishes the ability of the acquirer to finance such investments.

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Part 5 of UCC Article 8 provides the legal framework for (a) securities accounts, (b) the rights held in those accounts, (c) the rights of parties owning those accounts and (d) the obligations of those maintaining such accounts. Notwithstanding the chosen nomenclature, the statute applies to a broader universe than “securities.” It applies to “financial assets,” a category of property that is broader than “securities” and which is one key to the flexibility of UCC Article 8.

B. The UCC Article 8 Solution

The fatal flaw in today's Bitcoin ecosystem can be eliminated by changing the Article 9 collateral type of bitcoins from general intangibles to investment property, which is accomplished by using a structure that results in bitcoins being “financial assets” under UCC Article 8. “Financial assets” are assets held by a “securities intermediary”¹⁸ that maintains “securities accounts”¹⁹ for others (“accountholders”) in the ordinary course of business, provided the intermediary agrees to treat the assets as financial assets under Article 8. Thus, the bitcoin metamorphosis from general intangibles to investment property is accomplished by a securities intermediary agreeing to treat bitcoins credited to a securities account as a financial asset subject to Article 8.

The Article 8 structure has the following benefits:

•  Bitcoins are no longer subject to liens granted in general intangibles.

•  Bitcoins can be transferred free from existing security interests, provided the accountholder gave value for the bitcoins in the account without notice of existence security interests.²⁰

•  Existing (but unknown) security interests are eliminated.

•  Bitcoins held in such accounts are not property of the intermediary and would not be subject to claims of the intermediary's creditors.²¹

•  A security interests in the accountholder's account could be perfected by a control agreement (rather than a public filing), which maintains privacy.

•  Perfection by control also gives the secured creditor superior control, which should make credit both more available and less expensive.

•  This structure is well-known in commercial transactions, creates legal certainty, makes bitcoins held this way more attractive as collateral and will facilitate leveraging bitcoin investments with debt financing.

•  Since transfers of bitcoins are made by the intermediary on instructions of the accountholder, there is an additional layer of privacy for the accountholder.

•  The intermediary has the obligation to maintain bitcoins in a quantity corresponding to the total of all bitcoins credited to such accounts.²²

VI. Summary

Under the current Bitcoin ecosystem, parties lack information regarding existing security interests and liens. This circumstance leaves acquirers of bitcoins with the risk that their bitcoins may be subject to security interests and liens that diminish or eliminate the economic value of the bitcoins to owners.

For bitcoins to become useful in significant commercial transactions, the present uncertainties regarding existing security interests must be removed. These uncertainties not only affect the ability of the acquirer to be certain it is receiving the value it bargained for, but also greatly diminishes the ability of the acquirer to finance such investments.

The Article 8 structure provides the solution for these deficiencies. It is a system that has worked well for securities and is flexible enough to do the same for bitcoins.

¹ This article focuses on Bitcoin, but it is equally applicable to other similar de-centralized cryptocurrencies. Throughout this article, “Bitcoin” refers to the software protocol and “bitcoin” refers to the currency.

² The types of property under UCC Article 9 (exclusive of sub-types) are: accounts, chattel paper, commercial tort claims, deposit accounts, documents, general intangibles, goods (which includes inventory, equipment, fixtures and consumer goods), instruments, investment property, letter-of-credit rights, letters of credit, money and oil, gas and other minerals before extraction.

³ See footnote 3 for the list of types of collateral under UCC Article 9.

⁴ UCC §1-201(a)(24).

⁵ UCC §9-102(a)(47), UCC §3-103(a)(8), UCC §3-103(a)(12) and UCC §3-104(a).

⁶ UCC §9-102(a)(48) and UCC §9-102(a)(44).

⁷ UCC §9-102(a)(29).

⁸ See Section V(B) below for a discussion of how to accomplish the metamorphosis from general intangible to investment property.

⁹ UCC §9-315(a).

¹⁰ UCC §9-320 and UCC §1-201(a)(9).

¹¹ UCC §9-321.

¹² See, e.g., A Fistful of Bitcoins: Characterizing Payments Among Men with No Name, a study conducted by researchers at the University of California, San Diego and George Mason University https://cseweb.ucsd.edu/~smeiklejohn/files/imc13.pdf.

¹³ See FinCEN Guidance on Virtual Currencies (March 18, 2013) http://www.fincen.gov/statutes_regs/guidance/pdf/FIN-2013-G001.pdf.

¹⁴ Certainly law enforcement would be interested in such developments.

¹⁵ See, e.g., Protect Your Privacy, published by the Bitcoin Foundation https://bitcoin.org/en/protect-your-privacy.

¹⁶ The Uniform Law Commission notes that part of the genesis of the 1994 amendments was the stock market crash of October 17, 1987. The SEC found that one plausible reason for the precipitousness of the crash was the inability of market makers to obtain rapid credit due to uncertainties in UCC Article 8. http://tinyurl.com/pmkg72q.

¹⁷ The Official Comments to newly added UCC §8-501 noted: “Given the enormous variety of arrangements concerning securities that exist today, and the certainty that new arrangements will evolve in the future, it is not possible to specify all of the arrangements to which the term [securities account] does and does not apply.”

¹⁸ “Securities intermediary” is defined in UCC §8-102(a)(14). The prototypical securities intermediary is a trust company or a brokerage firm.

¹⁹ “Securities accounts” are a type of account defined in UCC §8-501(a).

²⁰ UCC §8-502. UCC §8-105 defines when a person has notice of an adverse claim, such as an existing security interest. Short of actual notice, the standard most likely to apply is the “willful blindness” test in UCC §8-105(a)(2)--one is aware of a significant probability of a security interest and deliberately avoids information that would establish that it exists. Given the difficultly tracing Bitcoin transactions to a person's name, this standard is unlikely to be met, unless one knows the real-world identity of the bitcoin transferor. Importantly, the fact that a secured party perfected its security interest by filing a UCC financing statement does not by itself, mean that all persons are deemed to have notice of that security interest. See UCC §8-105(e).

²¹ UCC §8-503(a), UCC §8-507.

²² UCC §8-504(a).